Richard Parkin: Pension freedoms vs small pots

Pension freedoms have liberalised retirement for many people. We are seeing a lot of activity in our group pensions business, with many retirees using the freedoms to take some cash and leave the rest invested, presumably to turn to income at a later date.

Yet one of the most actively used rules is not pension freedoms per se but the turbo-charged small pots rule the Chancellor announced in March 2014. With defined contribution saving in the UK still relatively immature and fragmented, we see a very large proportion of our customers using this approach to access cash.

The small pots rule was originally introduced in 2012 to allow those with one or two very small pots, then defined as £2,000 or less, to take benefits as cash as an annuity purchase at this level is unlikely to offer good value. Although this figure of £2,000 might not seem like much, it actually covered a large number of people who may have only been in their company pension plan for a short time.

In his Budget speech, the Chancellor increased the small pot limit to £10,000 and the number of pots that could be taken was increased to three, with the new limits coming into effect on 27 March 2014. The minimum age to take advantage of the rules was also later reduced from 60 to the minimum pension age, currently 55. These changes significantly increased the population that could take advantage of the rule and, as a result, we have seen a sharp rise in those using it to take cash at and before retirement.

But why is this important now that we have pension freedoms? Accessing pension savings under the small pots rule has a couple of advantages compared to accessing them under normal rules. Firstly, small pot withdrawals can be taken irrespective of other benefits and do not count towards the lifetime allowance. Secondly, and perhaps more interestingly, taking cash under small pots rules does not trigger the reduced money purchase annual allowance.

So while the natural inclination might be to consolidate smaller pensions into a single account, it is worth considering whether it might be more effective to use the small pots rules to take cash from these plans. In fact, you may find that even larger pots can be accessed under these rules and there is a couple of ways of doing this.

The first is to consider splitting the account across a number of arrangements. It involves creating separate arrangements within the same personal pension scheme so that one or more are less than £10,000.

Although the arrangements are in the same scheme the rule applies at arrangement level and so amounts under £10,000 can be safely cashed in even if the total holdings under the scheme are bigger. Not all providers may be willing or able to support this though. Those with lifetime allowance protection should also tread carefully as the creation of a new arrangement within an existing plan could endanger enhanced or fixed protection.

The second way is a really obscure bit of pension tax legislation that I had not heard of until earlier this year. I have tested this with a range of pension specialists since then and it seems that I am not alone. One for a pensions’ pub quiz tie-breaker if that’s not too scary a thought.

Basically, it applies where a customer has got protected tax-free cash and so will only apply for those with relatively old arrangements. The rule says the small pots test is applied after the tax-free cash is taken. Given some protected tax-free cash levels are high this could mean quite sizeable pots being eligible.

For example, Bob has an £18,000 pot with a protected tax-free cash amount of £9,000. He takes the tax-free cash amount of £9,000 leaving him with a residual value of £9,000. As this is below the small pot threshold he can now take this under the small pot rules. Simple.

Even those I spoke to who knew about this rule are not sure exactly why it exists. Whatever the reason, it could help you get that little bit more from your client’s retirement savings. At the very least, it could help you win that pub quiz.

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